Whose money will prevail as reserve currency?

October 20, 2009


-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

If there is one foreign exchange story that will run and run it is the one about the U.S. dollar (USD) and its future as the world’s dominant reserve currency.  The discussions on this topic have at least brought some agreement, namely that there is no clear alternative and therefore there can be no quick fix change.  That said, much uncertainty remains as to what can, if anything, eventually replace the dollar.

The basis for questioning the USD’s position as global reserve currency stems from its declining value and its “poor” fundamentals.  The dollar index is currently trading close to where it was 14 mpnths ago, ahead of the financial crisis.  At that point the USD had been on a downtrend for over two years. The widening in the U.S.’s budget deficit this year has worsened the fundamental backdrop and drawn attention to its “twin deficits”.  This has made creditor nations nervous. 

So, how bad are these fundamentals?

The U.S. current account deficit this year has actually improved.  However, once the U.S. recovery gets underway, many expect to see the current account widen again.  Textbooks suggest that a current account deficit should lead to a downward adjustment in the currency which will help address the imbalance.  This is not always the case.  Australia presently has a current account deficit of around 4.5 percent of GDP and the effective Australian exchange rate has rallied by 27 percent since January 1, 2009. 

Current account imbalances, while always a potential currency negative, only weigh if international savers become less keen to fund it.  Investment decisions will be determined by other factors such as relative growth and interest rates, political stability and fiscal coherence.   A huge USD negative this year has been the widening in the budget deficit to potentially 11 percent of GDP from 4.7 percent in 2008.   This implies huge bond issuance. 

To date, Treasury auctions have been well subscribed.  While supply has not caused the USD any clear problems, budget deficits of this size inevitably imply fiscal spending cuts which could weigh on growth for years.  This suggests limited growth in addition to low short-term interest rates which is a poor currency dynamic.

While a strong budget position is highly desirable for a reserve currency it is not the only factor.  Clearly a reserve currency needs to be fully convertible.  This requirement counts out the Chinese yuan (CNY).  The ability to cope with huge liquidity demands excludes currencies such as the Norwegian krone, Australia dollar and the New Zealand dollar.  The euro (EUR) fails the criteria insofar as there is no single sovereignty.  

Some argue that differing fiscal policies in the Economic and Monetary Union (EMU) have the potential to lead to friction, while others stress the geopolitical line that the absence of a single policy on defence would for some countries mean that the EUR would be an inadequate USD replacement.  This does not mean that the EUR will not take a greater role in the coming years.  There are signs that central banks have slightly increased their holdings of EUR along with the Japanese yen (JPY) this year and this trend may continue.

Looking forward, assuming U.S. fundamentals remain poor it is feasible that talk of a basket of reserve currencies will eventually become more relevant with the EUR and the JPY potentially playing a greater role and even the CNY playing a part in the next decade or so.  However, any adjustment in central bank currency reserves will be slow and is unlikely to lead to any tangible downward pressure on the USD particularly since creditor nations have an interest in protecting the value of their holdings.  As a result, any additional USD declines are likely to remain orderly.



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So much has been written and debated about this, Rolfe Winkler has a very informative Lunch Time Link of yesterday to The Economist.

I am going to be a real accountant and move away from supply and demand principles.

Why do we not simply add public and private sector assets (+ off-shore)together, subtract combined liabilities, remove double counting upon this consolidation, thereby calculating owners’ equity. If we are short, we revalue the assets and create a realistic non-distributable reserve.

For good measure, let’s convert it per capita to determine the equity value per citizen and repeat the exercise for the G20.

That might cause some people to jump from the Green Back onto the Hairy Back.

Posted by Casper | Report as abusive

Strange how the UK pound is not mentioned. It meets all the criteria expounded in this article, such as being single soverignty, fully convertible and the ability to cope with huge liquidity.

Posted by OG | Report as abusive

The global shift towards a multi-polar geopolitical world can only be realised if global trade utilises a basket of currencies/commodities – the world does not need a single reserve currency, it is simply not compatible with multi-polarism. Wake up America, you’re going to have to pay your debts back very soon!!

Posted by Edward Williams | Report as abusive

The simple answer is the international conversion of dollar denominated assets into some type of pre-agreed basket exchange implemented based upon the process of the conversion to the euro model by the European Union.

That way there is no divestiture compulsion and the basket of currencies, currency would provide a more stable international standard on which the large intergovernmental exchange transactions are based.

BTW, Jane you’re stunning.

Posted by James Reginald Harris, Jr | Report as abusive

How about the shekel (NIS)? Stanley Fischer is turning out to be the central banker par excellance.

Posted by jason | Report as abusive

Thanks, Jane, for the insight regarding the reserve currency. The lack of European single sovereignty had escaped me as a drawback for the Euro. It makes perfect sense and your article shows some value to the terrific drain on U.S. resources in being the “policeman to the world.” It has preventing the “Black Swan” event.
Looking back to 1944, who would pay $1.50 for a DeutschFranc? Or who would want to pay Chairman Mao 2 cents apiece to murder millions? Should we gamble against the advice of George Washington in 1792? “Do not get involved with European entanglements.”
The European blossom is a beautiful thing, The Chinese miracle also….
Fire up the carrier reactors, send the planes into the wild blue yonder, bless the soldiers. Keep this glorious garden blooming!

Posted by paul lennarson | Report as abusive

I’m not sure that arguing over which Fiat Currency backed by nothing is best to use as currency is the key argument.

By ramping up the printing press, the US is telling all foreign holders of US debt as well as it’s own citizens that they are defaulting on their debts in the most politically acceptable way.

The US defaulted on it’s debts in the 1970’s when Nixon took us off the Gold Standard. US Government will default again throwing the entire world into a spiraling economic depression.

Without sound money, any argument regarding currency is fraud.

Posted by Rayme | Report as abusive

“So, how bad are these fundamentals?”

Jane, wrong question, and wrong analysis.

The dollar problem insofar its role as reserve is not the fundamentals, albeit clearly the fundamentals have been much weakened. Fundamentals can be fixed. Difficult but fixable.

The dollar unfixable problem is that the United State has abused it profoundly. So much so that most of the world – leaders and people – are now convinced that they can no longer trust it. They just don’t believe the people who manages it – the Fed, Congress, Administration, major banks, will be able to fix the US economy with reserve interests (namely, foreign holders of trillions of dollar) in mind. The world is holding its breadth to get screwed again by the US Fed.

Therefore they will move away. Yes there is no true alternative now – one cannot replace a currency dominant for 70 years without a great deal of work. But if you only analyze the present currency situation you are gravely mistaken. Because when so many major countries have lost trust in the dollar, the momentum to do something about it is unstoppable. The dollar status is not mandated by the heaven. Abuse it, lose it.

Posted by The Real Deal | Report as abusive

Jane operates with-in perfect World of economical model.
But all problems are coming from the parameters that we fail to factor-in.

USA no longer has control over USD. The key to USD stability is in China hands.

China has ability and political will to see yuan as a World currency. It cannot happen overnight. Because today yuan is closely tight to USD. But China make first steps to introduce yuan as one more currency and potentially the World currency.

China issued yuan denominated loans to other countries like Argentina.

Last month China ran first action of yuan sovereign bonds in Hong-Kong.

China gov has more than enough USD bonds to unleash series of “micro shocks” to scare markets from USD to the new reserve currency. That would be…

At the same time gov controlled enterprises hold tons of derivatives and can shock almost every market. They just unleash one more shock

http://www.reuters.com/article/rbssFinan cialServicesAndRealEstateNews/idUSSP4732 7420090831

It was another in 2008 when some Chinese banks refused to pay by FX contracts.

It is unclear if these actions cause more damage to China reputation than to USD.
The alarming fact that the force behind these actions is State-owned Assets Supervision and Administration Commission.

Posted by Sergey | Report as abusive

Apologies Jane, however I find it repugnant that the Great Debate confines itself to issues regarding global finance and economics/politics. Particularly in the face of human suffering around the globe brought on by the activities of greedy, self absorbed corporate moguls and investors.

The planet and all life on it is slowly dying. Humanity is descending into a depravity of biblical proportions. Yet there seems to be no end of those ready to comment foreign trade, monetary policy, banking regulation…etc.

There are no correct policy decisions in any number of these fields that will solve our problems. That would be merely treating the symptoms. There is a larger problem. Greed. Capitalism has become a religion. Nothing can be done if the market won’t support it.

The Rapanui I am sure were true to their religion as the cut down the last trees on Easter Island in order to build and erect one more monolith to their gods so that the harvests would come back. Never mind that cutting down all the trees eroded their good soil. With no trees left to build boats, they couldn’t even leave the island.

Posted by Anubis | Report as abusive


Posted by Roger Swain | Report as abusive